Final salary savers may be forced to pay pensions tax on their pay rise if contributions cap is slashed to £30k

More workers on final salary pension schemes could be penalised for getting a pay rise under tax relief allowance changes reportedly being considered by the Government.

Senior coalition members are believed to be considering reducing the maximum amount people can contribute to their pension pots each year from their tax-free pay from £50,000, to £40,000, or even £30,000.

But as well as bringing thousands more wealthy savers into tax on their pension contributions, reducing the allowance could also trigger a rise in the number of one-off tax charges levied on those on final salary schemes who receive pay rises - hitting those who are a long way from contributing £30,000 of their own money directly into a pension.

Taking the shine off: A pay rise is always welcome, but more people could end up paying tax on their pension contributions if their salary increases.

This comes due to the way that final salary benefits are calculated, effectively salary increases are multiplied up to reflect what needs to go into a pension pot to deliver their benefit in retirement.

It means that while those with defined contribution pensions would be able to put in up to £30,000 directly before tax relief was axed, savers with long-standing defined benefit final salary schemes would find a decent pay rise could be enough to send them over the limit.

High earners on more than £112,500 would also face a tax bill for their pension contributions if the £30,000 limit was brought in.

Hargreaves Lansdown has calculated that for a worker with 30 years’ service in a 60th final salary scheme, a pay rise of £3,750 in a single year would send them over the limit if the allowance was reduced to £30,000, meaning they’d be taxed on pension savings above that amount.

Currently a worker on the same pension scheme would not incur tax on their pension contributions until their salary jumps by £6,250.

Meanwhile those with 20 years’ service in a 60th scheme would be taxed on their pension contribution if their wages rose by £5,625 if the allowance was reduced to £30,000, compared to the £9,375 it would need to jump before they are liable for tax now.

This is because the annual allowance calculation for final salary schemes looks at the jump in total pension rights from one year to the next.

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A significant jump in salary would feed directly into a jump in the value of pension rights for schemes linked to salary, as such a pay bump would incur a tax charge in the year it happens, but not in subsequent years.

The possibility of Chancellor George Osborne announcing changes in next month’s Autumn Statement has been met with dismay in a pensions industry eager for stability and already working through major changes in the wake of auto-enrolment.

There is also anger that savers are once
more being penalised to boost government coffers, with allowance
reductions to £40,000 or £30,000 expected to generate £600 million and
£1.8 billion respectively.

Stop tinkering: Tom McPhail, of Hargreaves Lansdown, says the industry wants the Government to slow down the rate of changes being made to pensions.

Currently those on final salary
schemes have to be earning £187,500 before they have to pay tax relief
on their contributions each year, according to Hargreaves Lansdown.

If
the allowance was reduced to £30,000 it could make everyone earning
over £112,500 liable to pay tax on a portion of their contributions,
though the salary trigger level could be slightly higher as
these figures do not take into account the impact inflation has on
annual allowances.

Jason Hollands, managing director of
Bestinvest, said: ‘Such a move would come at a point when, according to
the Department of Work & Pensions, pensions savings are already at
their lowest level for a decade and research has suggested that even one
in four people in the 40 per cent tax bracket don’t pay into a pension,
despite the clear attraction for them to do so.

‘So what, some might argue, £40,000 is still a lot of money to save in any one year!

‘That
is true but the reality is that many middle class investors have to
play serious catch up with pensions as they approach retirement, making
bigger contributions only once their children have grown up and their
mortgages are paid off and they are confront by the reality of how much
they need to boost their fund by to generate a decent retirement
income.’

Tom McPhail, head of pensions research at Hargreaves Lansdown, said: ‘Investing in a pension is the most tax efficient way to save for retirement, which is perhaps why the politicians can't resist tinkering with the rules.

‘Higher rate tax payers and final salary scheme members will lose out from any tax raid. We hope that George Osborne will resist the temptation to raid our retirement savings but we aren't confident that he will be able to resist the lure of what for him must seem like easy money.’